Those big Rubio tax cuts

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They were rubbished by Mike Konczal and Paul Krugman, but there is some blowback from Gregory Mankiw and an interesting discussion ensued at Econospeak.

Krugman v. Mankiw on Rubio’s Tax Cut – Show Me the Model

Greg Mankiw of Team Republican tries to counter an attack from Paul Krugman on Rubio’s tax cut for the rich, which may come as breathing spell from the flap over that “analysis” by Gerald Friedman (my two cents on that flap in a bit). Greg says Rubio is proposing the David Bradford plan:

Good tax policy should be pro-growth, simple, and fair. An income tax, unlike a consumption tax, penalizes saving, which undermines economic growth and introduces complexity. An income tax is often thought to be fairer than a consumption tax, however, because it taxes saving, which is disproportionately done by higher-income individuals….The reduction in capital accumulation reduces labor productivity and lowers real wages throughout the economy, depressing the standard of living of future generations. Some studies have found that a switch to consumption taxation would increase the size of the U.S. economy by as much as 9 percent in the long run, although other studies estimate smaller gains.

Bradford does cite these studies and we will note one later. Can we take this back to the debate over the 1981 tax cut and note why I am so big on Show Me the Model? Voodoo economics was coined by George H. W. Bush as he did not believe Art Laffer had a real model of how large tax cuts could lead to a miracle growth. After all, standard economics tells us that tax cuts lead to less national savings, higher real interest rates, and crowding-out of investment. All of which happened. Laffer’s excuse for a model was a cocktail napkin which does not cut it. For what is worth, the Congressional Budget Office does model out potential output, which had been growing at a 3.5% clip since the end of World War II until 1980 but slowed to a 3% clip for the Reagan-Bush era. As Peter Dorman noted, Gerald Friedman failed to model out potential output and its projected growth path under the proposals of Bernie Sanders:

He never presented his model. The appendix to his report jumps immediately to parameter estimates, but there is no list of all parameters nor a formal model displaying how they relate to one another. I take it that the implicit model calculates GDP growth from spending projections subject to a multiplier, and that this translates into labor demand with productivity as a residual. The microeconomic results are determined by macro outcomes plus additional sector-specific factors. There does not appear to be a simultaneous relationship between macro and micro (especially labor market) outcomes, which is a cause for concern.

His defenders seem to miss the point with respect to the microeconomic or potential output side. Yves Smith wrote:

Friedman did this using a completely standard model. So the real issue is about the assumptions

A standard multiplier model without any consideration of potential output might be fine for forecasting a depressed economy over the next few years but not for a decade. In some ways, this defense from Jamie Galbraith was worse:

There are not many ambitious experiments in economic policy with which to compare it, so let's go back to the Reagan years. What was the actual average real growth rate in 1983, 1984, and 1985, following the enactment of the Reagan tax cuts in 1981? Just under 5.4 percent. That's a point of history, like it or not.

Of course the CBO model would note we had a GDP gap back then near 8% with potential growing at 3% per year. CBO now says the gap is around 2.8% and it is growing at only 2% per year. But is CBO the only model? Of course not. Menzie Chinn had an excellent discussion:

Note: I do not know what the output gap actually used in the Friedman study, as it is not reported…. One thing that should be remembered is that the trend line extrapolated from 1984-2007 implies that the output gap as of 2015Q4 is … -18%. A graphical comparison which highlights the implausibility of the -18% output gap is shown below… I want to stress that estimating potential GDP and the output gap is a difficult task

Indeed it is difficult but using trend lines is how Lawrence Kudlow does this for the National Review. Let’s not go there. Sandwichman wants to ditch NAIRU (I agree) and Mark Thoma has a must read discussion. All of this is fine but I still say Show Me the Model and as one does, please note the latest from Brad DeLong:

These are principal causes of "hysteresis". I do not believe that the output gap is the zero that the Federal Reserve currently thinks it is. But it is very unlikely to be anywhere near the 12% of GDP needed to support 4%/year real growth through demand along over the next two presidential terms. We could bend the potential growth curve upward slowly and gradually through policies that boosted investment and boosted the rate of innovation. But it would be very difficult indeed to make up all the potential output-growth ground that we have failed to gain during the past decade of the years that the locust hath eaten

Team Republican will likely have their models so permit to reach back to one of the models mentioned by Bradford in discussing something akin to the Rubio proposal which was an excellent paper entitled Simulating U.S. Tax Reform:

This paper uses a new large-scale dynamic simulation model to compare the equity, efficiency, and macroeconomic effects of five alternative to the current U.S. federal income tax. These reforms are a proportional income tax, a proportional consumption tax, a flat tax, a flat tax with transition relief, and a progressive variant of the flat tax called the 'X tax.' The model incorporates intragenerational heterogeneity and kinked budget constraints. It predicts major macroeconomic gains (including an 11 percent increase in long-run output) from replacing the federal tax system with a proportional consumption tax. Future middle- and upper-income classes gain from this policy, but initial older generations are hurt by the policy's implicit capital levy. Poor members of current and future generations also lose.

This estimated 11% gain happens only very slowly over time. Tax cuts do not pay for themselves and the proposition that everyone gains is not true. Maybe Greg Mankiw wants to pretend otherwise and maybe he has in mind a different model. But like Gerald Friedman – he has not laid out a real model.

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Let us raise a few issues as well here:

Marco Rubio’s original family-friendly tax cut policy was quickly expanded once questioned by the guardians of conservative supply-side orthodoxy. Most notably, he would eliminate all taxes on incomes from capital gains and dividends. This income from holding financial assets is incredibly concentrated at the top. As Josh Barro notes, Rubio’s tax plan “would raise incomes for the top one-thousandth of taxpayers by 8.9 percent — that is, an average tax cut of more than $900,000 per year — because of its sharp cuts in tax rates on business income and capital income.”

Marco Rubio's Radical Alignment with the Financial Industry - Roosevelt Institute

In normal times it might very well be better (although not more equitable) to tax consumption rather than income, as a tax on income also taxes savings and might indeed reduce growth by making finance more expensive.

However, we are not in normal times. Savings are plenty but wages have been stagnating for decades while the top of the income and wealth ladder has accumulated most of the gains from economic growth. This is where those savings are coming from, as it happens. 

This is now clearly a drag on growth itself. Companies sitting on record profits, record cash levels and facing record low financing cost but it's very difficult for most to grow the top line when wages are not growing, so there is no investment boom either despite the very healthy financial position and record low financing cost.

Why add to production capacity when you have trouble filling the existing one, which is why we have payout ratios (dividends and stock buybacks) in excess of 90%, which concentrates even more income at the top, reinforcing the problem. 

And what does Rubio want? Make this all much more easy, basically. Is there any evidence this will work? Probably not:

Besides the massive distributional implications, this has consequences for finance’s power over the real economy. A lot of people are looking at the influence of the financial sector and the issue of “short-termism,” or the extensive prioritization of dividend and buyback payments to shareholders over real investments. Independent of its effects in driving inequality, Rubio’s removal of any taxes on dividends and capital gains would certainly scale this issue. As Danny Yagan has found, the substantial cuts to dividends passed by the George W. Bush administration didn’t boost investment. It did, however, boost dividends, something other research in finance has found. If you are worried that corporations prioritizing payouts instead of investments is a challenge to our economy, taking the extreme act of eliminating taxes on dividends and capital gains would send that spiraling.

Marco Rubio's Radical Alignment with the Financial Industry - Roosevelt Institute